There are multiple paths to good returns for shareholders.
Shares of cosmetics retail chain Ulta Beauty (ULTA 1.50%) are down more than 30% from all-time highs. But this is not a business in decline at all. And it’s quite easy to prove.
Ulta Beauty had zero long-term debt as of February 2024. As investing great Peter Lynch used to say, “It’s very hard to go bankrupt when you don’t have any debt.” To this I’ll add that it’s even harder to go bankrupt when a company is also profitable. And Ulta is very profitable with an operating-profit margin of 15% in its fiscal 2023.
To reiterate, the stock is down. But there is a reason it’s down: At a recent investor conference, management said that fiscal 2024 started below its expectations. Consequently, it believes that it will deliver numbers at the low end of its financial guidance.
I believe this is clearly a classic case of investors overreacting to the news. After all, Ulta Beauty didn’t pull its guidance. To the contrary, management said it would deliver on its financial guidance, albeit at the low end.
For perspective, the low end of its net-sales guidance for fiscal 2024 is $11.7 billion. That’s still a year-over-year increase of 4%.
The company has a clean balance sheet, is profitable, and is still growing at a modest pace — as I said, it’s easy to establish that this is not a business in decline. But because the stock is down, investors are now facing one of two likely outcomes. And both are good for shareholders.
Scenario No. 1: Ulta Beauty bounces back to normal
Ulta Beauty stock currently has a price-to-sales (P/S) ratio of 1.7, which is really cheap. Looking at its 10-year chart, it has traded with a P/S as high as 4 and as low as 1. But it has averaged a P/S valuation of 2.6.
ULTA PS ratio data by YCharts.
Let’s say that investors slowly realize that the stock is cheap and fears are overblown. If investor demand picks back up and the stock gets back to a normal valuation, it could have around 50% upside. That’s a good deal.
Moreover, outside of the stock market crash for the pandemic, Ulta Beauty hasn’t ever been this cheap in the past decade. Therefore, it’s hard to imagine that shares have much more downside today. Bad expectations are already reflected in the cheap price.
In short, the stock could have little downside, with 50% upside opportunity.
Scenario No. 2: Ulta Beauty stock stays cheap
It’s also possible that the stock stays cheap or even gets cheaper (even if I find that unlikely). This would counterintuitively be good for patient long-term investors as well.
Over the last decade, Ulta Beauty’s management has spent nearly $6 billion repurchasing its shares. This boosts per-share value for those who hold.
ULTA average diluted shares outstanding (quarterly); data by YCharts.
Given that it’s a profitable business with a history of returning cash to shareholders, Ulta Beauty is likely to continue buying back stock at a generous rate. The kicker is that when shares are cheap, as they are now, a share repurchase program gets more bang for its buck.
Why it’s a win-win situation
I’ll concede that it’s possible that Ulta Beauty will lay an egg when it reports financial results for its fiscal first quarter of 2024 on May 30. After all, the aforementioned investor conference was mere weeks after management had given financial guidance. Something had changed in a short time, and it’s possible things have further deteriorated at a rapid rate.
However, I find it more likely that management was merely noting a modest temporary slowdown for cosmetics spending; it’s not talking about a permanent consumer shift away from its products and services.
If this is just the normal ebb and flow of business, then the company is still set up well for the long haul — that makes it still a quality investment candidate. And because the stock is cheap, either the valuation will bounce back or management will be able to repurchase more shares. Either way, Ulta Beauty’s shareholders win, making this a smart stock for patient investors to buy now on the dip.
Jon Quast has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Ulta Beauty. The Motley Fool has a disclosure policy.
